Both Bill Ackman and Bruce Berkowitz seem to think that there is money to be made in Fannie Mae (FNMA) and Freddie Mac (FMCC), the bailed out mortgage finance companies. Through Pershing Square - Ackman's hedge fund -- the value oriented investor bought almost 10% of both companies in the public market. Ackman's bet took place after Berkowitz proposed to capitalize parts of both mortgage giants. Should you also buy into Berkowitz's idea?

The Berkowitz case on Freddie and Fannie.

Not only Ackman and Berkowitz are behind the idea. A wide group of funds are working on a proposal to transfer a big part of the businesses controlled by the mortgage giants to the private sector. If the idea ends up working out, Fannie and Freddie shares should soar even when they are up by more than 800% year-to-date (ytd).

After the 2008 bail-out, the US treasury decided not to take over the full company. The reason is simple: If the government had taken full ownership of Freddie and Fannie, it had had to transfer trillions of dollars of mortgage guarantees into its books. Instead, in exchange for its financial support (more than $188 billion), the US Treasury took a new class of senior preferred shares and warrants that would allow the Treasury to acquire nearly 80% of Fannie and Freddie common stock.

Berkowitz's reasons to buy into Freddie and Fannie are clear. The senior preferred shares that were given to the Treasury in exchange for its support had initially paid a 10% dividend. That said, last year, the government changed those terms. The new terms are as follow: Since 2013, the mortgage finance companies have to send all their profits to the Treasury in an action called “dividend sweep.” In such way, Fannie and Freddie don’t owe anything to the Treasury if they make a loss but the companies send everything to their controlling shareholder when they turn profitable. Lately, Fannie and Freddie have been highly profitable. The mortgage finance companies have been able to show a combined net income of $117 billion ytd and, if the housing market keeps on recovering (almost a sure thing), they would have pay the US government more than $180 billion in 2013 alone. Since those payments do not count as re-payments to the US Treasury, Berkowitz and Ackman see an opportunity. They argue that the government is confiscating the their share of the earnings made by Fannie and Freddie – if you own 80% of any asset you can not claim 100% of its up-side potential. Hedge funds are offering to re-capitalize parts of the mortgage finance companies in exchange for their true shareholder rights on those parts.

Bottom line

Of course, Berkowitz's ideas are not shared by the US Treasury, which is looking for other ways to wind down Fannie and Freddie in a way that can minimize the impact on the availability of mortgages. In a recent statement a US Treasury official said "the administration remains committed to reforming the housing finance sector by responsibly winding down Fannie and Freddie and ensuring that any new system preserves broad access to credit for responsible borrowers, strengthens the economy and promotes financial stability." The stakes are not small, after all, through Fannie and Freddie, the government guarantees 80% of all new mortgages in the country. I think there is money to be made in Fannie and Freddie but it will take a long time to find a solution that looks fair enough for all parties involved - private investors and the US government.

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